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New Delhi/Mumbai: The International Monetary Fund (IMF) and the Reserve Bank of India (RBI) highlighted persistent risks to the banking system owing to asset quality concerns, in separate financial stability assessments released on Thursday. The multilateral institution urged the Indian government to consider privatizing weak public sector banks (PSBs) by selling their viable assets rather than merging them with stronger banks, since that would undermine the viability of the acquirer.

It also recommended increasing the central bank’s independence, expanding other financial regulators’ resources, introducing a risk-based solvency regime, and enhancing safety net measures such as deposit insurance and emergency liquidity assistance to improve financial stability.

The IMF said that though India’s key banks appear resilient, the system is subject to considerable vulnerabilities and their capital needs range from 0.75% of GDP in the baseline to 1.5% of GDP in the severe adverse scenario.

“Stress tests show that while the largest banks are sufficiently capitalized and profitable to withstand a deterioration in economic conditions, a group of PSBs are highly vulnerable to further declines in asset quality and higher provisioning needs," it said. These vulnerable banks “would require additional capital under the baseline scenario and some would almost deplete capital buffers due to growing NPAs (non-performing assets) and provisioning needs if stress intensifies. Capital needs are manageable in the aggregate, ranging between 0.75% of GDP in the baseline to 1.5% of GDP in the severe adverse scenario."

The stress tests conducted by IMF experts covered the 15 largest banks, including 12 PSBs, which account for 71% of the banking sector assets. RBI’s stress tests also show a rise in non-performing assets (NPAs) even though the regulator said that India’s financial system as a whole remains stable and stress in the banking sector, “while significant, appear to be bottoming out".

Under the central bank’s base case scenario, gross NPAs in the banking sector may rise from 10.2% of gross advances in September to 10.8% in March and further to 11.1% by September 2018. In its June financial stability report, RBI had projected that the banking system’s gross bad loan ratio will rise to 10.2% of the total loan book by March later if economic conditions stay the same.

A rising level of bad loans would also hit the capital adequacy ratio of banks, the regulator warned. Capital adequacy ratio is an indicator of a bank’s financial strength, expressed as the ratio of capital to risk-weighted assets (CRAR).

Under its base case scenario, two banks may have a CRAR below the minimum regulatory level of 9% by March, the RBI report said. However, if macro conditions deteriorate, six banks may record a CRAR below 9% under severe macro stress scenario and the system level CRAR may decline from 13.3% in March 2017 to 11.2% the next year, the report said.

“While the ongoing deleveraging in the heavily indebted parts of the corporate sector and muted credit growth in the public sector banks pose a risk to growth, the decisive recapitalisation move by the government could provide the much needed fillip to private investment going forward. If we keep our financial system, especially, the banking sector, in good shape, we can catch the tail winds of the external conditions. That would mean keeping the economy on even keel in terms of macroeconomic balance," said N.S. Vishwanathan, deputy governor of RBI.

The IMF, on the other hand, called for reducing the state’s ownership stake in PSBs to the mandated minimum of 52%.

“The recapitalisation and restructuring strategy should support the authorities’ aim toward further consolidation of the banking industry, while avoiding mergers that could undermine the viability of the stronger PSBs. A blueprint for restructuring and privatization, with clear time frames, could usefully guide these efforts," it said.

The multilateral institution said that a mix of greater participation of the private sector in capitalizing PSBs and full privatizations would boost the banking sector’s capacity to support credit and reduce moral hazard and fiscal contingencies.

On the privatization of state-run banks, finance minister Arun Jaitley, speaking at the Hindustan Times Leadership Summit last month, said such a move needs political acceptability. “I am pragmatic to realize that political opinion is not ready to take that decision," he added.

The finance ministry recently announced an unprecedented Rs2.11 trillion PSU bank recapitalisation plan including recapitalisation bonds of Rs1.35 trillion, which amounts to 1.3% of GDP. On 1 November, the government announced the establishment of an alternative mechanism panel, headed by Jaitley, to seek consolidation across state-owned banks.

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